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A wave of corporate breakups has rippled through industry after industry over the past several years. This has happened in consumer goods, for instance, with Kraft Foods’ spin-off of its North American grocery business; in materials, with Alcoa’s split into separate aluminum and engineering businesses; in technology, with HP’s separation of services and software from printers and PCs; in energy, with Danish industrial conglomerate A.P. Moller-Maersk’s divestiture of its oil businesses; and in health care, with Siemens’ spin-off of its medical technology division. The trend started in the 1980s in the United States and reached Europe in the late 1990s, but it has intensified in recent years, as more vocal investors have pressed for more focused business structures.1
You might wonder if we are finally seeing the long-anticipated demise of the diversified public corporation.2 After all, both finance and strategy scholars, while recognizing that a little diversification can be a good thing, have argued for years that greater amounts of it are detrimental to performance and value creation, particularly when businesses in a portfolio aren’t clearly linked.3 This idea that the relationship between diversification and performance follows an inverted U-shaped curve has become established wisdom in management literature.4 It continues to permeate leading textbooks on corporate strategy.5
Why would companies diversify beyond optimal levels? Because, traditional thinking suggests, managers have enjoyed higher compensation levels and faced fewer takeover risks in large, diversified corporations than in smaller, more specialized companies. So, many observers assume that it was in response to greater capital and product market pressures in more liberalized, well-developed economies that companies de-diversified and focused on one or a narrow range of activities that they know best.6
Though this tidy narrative is intuitively appealing, two aspects of it don’t hold up. First, some companies continue to be highly diversified — and do well. Many private equity groups and conglomerates such as Alphabet or the Mahindra Group are thriving in multiple lines of business. This observation resonates with recent research7 suggesting that the capacity to manage diversification differs more widely between companies than previously thought. Second, if the decline in diversification were due to external pressures, we would expect the worst diversifiers (those with the most detrimental performance effects) to have refocused or gone out of business, thus raising the average returns of diversification across all companies.8
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Clearly, there is a richer story to explore, and that is why we embarked on two lines of inquiry: To examine the relationship between diversification and corporate performance, we performed a meta-analysis of five decades’ worth of empirical research. And to identify factors that account for successful diversification, we conducted case studies of more than 30 large, diversified corporations, in a range of industries, that have consistently outperformed their more focused competitors. We complemented publicly available materials with interviews of managers, analysts, and industry experts. (See “About the Research.”)
We found that high levels of diversification aren’t necessarily bad for performance — and that diversified companies aren’t a dying breed. While average levels of diversification have declined over time, levels of related diversification have begun to increase since the late 1990s. Companies are considered related diversifiers if they operate in similar product or service markets. Our research further suggests that this kind of diversification strategy continues to enhance companies’ operational performance and capital market valuations.
We also found that the average effect of unrelated diversification on performance, while still negative, is now so small that it is not significantly different from zero anymore. (That’s a big shift from the past; between the 1970s and the 1990s, companies experienced strong negative effects.) This result holds with respect to various measures of performance, including capital market measures, such as market value and risk-adjusted market returns, and accounting indicators, such as profitability and sales growth.9
How might these changes be explained? Perhaps by the apparent decline in the costs of diversification. In recent years, the risk of value-destroying behavior seems to have been reduced by new trends such as the increased efficiency of capital markets, a stronger focus on corporate governance, the proliferation of value-oriented key performance indicators (KPIs) and incentives, and improved transparency due to advances in information and communications technology. And meanwhile, the benefits of diversification persist. During the financial crisis, many diversified companies benefited from easier and cheaper access to capital.10 Companies may also realize financial and organizational advantages if they can tap into richer internal markets for knowledge and managerial talent. As the recent examples of Amazon and Alphabet show, a diversified company can be a strong organizational model for transferring technology into new businesses in the pursuit of growth. Diversification here has less to do with whether a company is active in many industries but rather with the range of applications for knowledge, technology, and other intangible assets.
If diversification strategies no longer harm performance across the board, when do they pay off? Our research indicates that companies tend to reap the rewards when they take three steps:
1. Limit the number of business models in the portfolio and support each one with a strong, cohesive operating model. The challenge of managing diversification is not driven by the number of business units, products, or industries that a company covers but rather by the diversity of its business models. A business model explains how an organization will create value, deliver it to customers, and capture it for the company itself.11 Successful diversified companies tend to have a dominant logic governing their portfolio that allows them to leverage expertise and experience across a wide range of businesses. They avoid the trap of being lured into businesses that seem related from a product or market perspective (for instance, because they target the same customers or use the same raw materials) but actually require different capabilities.
For example, consider easyGroup, the British private holding company best known for its low-cost airline, easyJet. The group’s portfolio has expanded significantly to include a collection of businesses with the “easy” brand, ranging from travel-related ventures, such as easyBus, easyCar, and easyHotel, to offerings geared toward daily living, like easyCoffee, easyGym, and easyMoney. From a product perspective, the group looks like a highly diversified conglomerate. However, its subsidiaries have something critical in common: All of them offer “no frills” services.
Describing the activities of the original business, easyJet, in terms of its business model rather than its industry enabled the company to expand into a whole range of other services that follow a similar logic. All the businesses benefit from a strong group brand that signals a clear value proposition to price-sensitive consumers across product markets. A stringent focus on standardization of products and services and cost discipline provide the operational foundations for this low-cost positioning. And the online distribution system leads to further synergies and learning across businesses.
As the easyGroup example illustrates, shared characteristics among businesses in a portfolio may relate to different aspects of the business model. They may address value creation (degree of product customization, share of revenues from product sales versus services), value delivery (capital intensity, distribution models), or value capture (revenue mechanism, competitive differentiation). The similarities are essential for competitive advantage in each industry. That’s how the group can best support the success of its business units.
A company’s operating model is central to its business model and, empirical evidence shows, a chief driver of performance.12 It’s the sum total of the capabilities that enable the business to effectively and efficiently create, deliver, and capture value. The operating model is also a philosophy, a consistent set of management processes and practices that defines how decisions get made and objectives are set.
A company can leverage a strong, cohesive operating model to manage and improve performance across a diversified portfolio of businesses. A familiar example is Danaher, a science and technology company with $18 billion in revenue from more than 25 operating companies in industries as diverse as diagnostics, life sciences, dental care, and environmental and applied solutions. While these businesses involve different products and serve diverse markets, they share a number of important characteristics. They offer small, medium-priced, performance-critical components of high-value systems that are difficult to substitute. Products are typically assembly-manufactured, with low customization and at medium volumes. The businesses are active in relatively small markets with high growth and low volatility, and with a fragmented customer base, which are less attractive for large, sophisticated competitors such as Siemens or General Electric.13
The company’s operating model, called the Danaher Business System (DBS), is consistently applied to all business units. It includes four components that support the broad objective of “helping realize life’s potential”:
- People: A corporate talent funnel allows the company to carefully manage the development “journeys” of 2,000 high-potential employees through monthly reviews and extensive training in DBS principles and tool kits.
- Plan: An annual strategic planning process focuses on challenging business units’ management thinking and identifying five to seven strategic priorities for each business.
- Process: A Kaizen-inspired continuous improvement process is supported by more than 50 tool kits, the DBS Office (which consists of about 20 members who rotate into the various businesses), and business unit experts.
- Performance: The company translates strategic plans into specific targets, actions, and owners, and conducts monthly reviews of each unit’s 15 KPIs. DBS measures performance in four areas: quality, delivery, cost, and innovation. Performance assessments are linked to the strategic plan, occur at frequent and regular intervals, and include objectives with varying time horizons.
The operating model creates value by emphasizing discipline and continuous improvement. This is particularly important for the Danaher businesses with high average gross margins. Unless well-managed, such margins have a habit of being self-destructive, as they tend to encourage lax management practices. Danaher also generates considerable value by applying DBS to newly acquired businesses. The company has repeatedly improved operating margins by seven percentage points or more in what were already high-margin businesses at the time of acquisition. For example, after Danaher’s acquisition of Tektronix in 2007, its sales grew by 14.9% and margins increased to 15.8% in 2008.
2. Tailor the corporate parenting strategy to the portfolio. If the value of a diversified company is to be greater than the sum of its parts, the corporate parent needs a strategy for adding value.14 Its role and activities must be aligned with the needs and opportunities of the portfolio businesses.
A corporate center can add value in many ways, of course. It may offer financial advantages by providing easier and cheaper access to external and internal funds, treasury management, and tax optimization. It may provide expertise and tool kits for strategy analysis and execution (for example, in mergers and acquisitions) to help business units with long-term value creation. The businesses may further benefit from corporate functions and resources that offer distinct capabilities or cost advantages. And in some companies, the center adds value through even deeper operational engagement — for instance, by fostering cooperation among portfolio businesses, closely monitoring operational performance, leading improvement initiatives, or even restructuring struggling business units.
But a sound parenting strategy is more than just a random collection of value-adding activities. You need to sort out the right level of involvement. Sometimes a light touch is best; sometimes units need more hands-on guidance.15 (See “What Kind of Parent Do Your Business Units Need?”)
Our experience tells us that corporate parents ought to take three factors into account when deciding how much to intervene: the portfolio strategy, the needs of the businesses, and the corporate center’s capabilities. Those elements should all be in sync.
- Portfolio strategy. The size, homogeneity, synergy potential, and stability of the corporate portfolio should all influence parenting strategy. In general, the higher the number of business units and the more diverse they are, the less involved the parenting strategy should be. This is simply a result of limited managerial capacity for closely monitoring a diverse set of businesses and the increasing cost of complex corporate processes in larger portfolios. But if the business units are closely related and have high synergy potential, it may make sense for the parent to get more involved and actively foster collaboration among units. Strong parent involvement and centralization of activities require a stable portfolio, however. If significant changes in portfolio composition are expected and the corporate center needs to move assets around, the parenting strategy should not involve too many rigid structures or fixed linkages among business units.
- Units’ needs. The industry, business model, and strategic priorities of each business in the portfolio will help determine which parenting style to use. For example, in highly dynamic industries where players must make fast decisions close to the market, light corporate involvement often makes sense, whereas a business unit in a highly regulated environment may benefit from the political clout and support of the parent. If a portfolio business has a strong focus on exploiting existing capabilities and reducing costs, a centralized model may be favorable, whereas a focus on exploration and innovation may call for decentralization. When business units’ needs vary widely — for example, when very different skill sets must be managed — it can be difficult for a parent to accommodate them all, since activities that add value for one unit may destroy value for another. A responsible corporate parent should understand why the needs of the business units differ, rather than impose standard recipes on all units indiscriminately.
- Corporate capabilities. When choosing a parenting strategy, the corporate center should also consider the capabilities at its disposal. Those may be found in people (individuals with relevant expertise or experience), processes (for strategic planning, mergers and acquisitions, due diligence, investment valuation, and so on), or systems (for risk management, say, or talent development). Different parenting strategies demand different corporate capabilities. While less-involved parents mainly require strong business judgment and financial capabilities, parents that want to act as a strategic or operational guide need a superior understanding of the relevant markets and sharp business development skills. If the corporate center wants to provide functional leadership to improve units’ performance, it must, of course, excel in key functions (particularly in finance, strategy, and human resources).
Corporate parents should maximize their net — not total — value contributed. That’s important to remember, because an overly (or ham-handedly) involved parent can unwittingly destroy units’ value in many ways. For example, managers at the corporate center who do not understand the specific requirements and success factors of particular business units may impose policies and services that are inappropriate. Inefficient corporate processes can add costs and delays, not to mention considerable confusion over objectives and expectations on the part of hard-pressed business-unit managers. Businesses may waste time and resources on internal coordination with other business units, in an attempt to influence corporate policies or compete for power.
Successful multi-business companies, well aware of such risks, are constantly on the lookout for ways to limit the costs, complexity, and bureaucracy that corporate involvement can induce. For example, Danaher manages its large portfolio and adds significant parenting value with a corporate staff of fewer than 100 employees. In our experience, many corporate parents would be well-served by doing less rather than more.
3. Allocate resources based on clear portfolio roles. Once the portfolio and parenting strategies are set, disciplined capital allocation is the most effective instrument for translating these strategies into action. A Boston Consulting Group study of some 7,000 large global companies showed that companies in the top third of stock market valuation relative to their peers invested approximately 50% more in capital expenditure than their peers and achieved 55% higher returns on assets and 65% higher sales growth.16 They achieved this by consistently focusing their investments on their most attractive businesses and by being disciplined in investment project selection and governance.
Successful diversified companies invest in the best businesses, not just in the best projects. While they do assess the potential of individual investment proposals, their first consideration is the strategic attractiveness of a business and the extent to which future investments can strengthen its competitive advantage and sustain high returns. That approach helps them avoid common capital-allocation pitfalls, such as the maturing-business trap (not reducing capital expenses after a business’s growth plateaus or starts to decline), the egalitarian trap (giving every unit its “fair share,” regardless of potential), or the myopia trap (sacrificing long-term value creation for short-term financial performance).
Assigning clear roles to the businesses in a portfolio is a good way to link investments to strategic potential. A diversified energy company that one of us has worked with classifies its various units as development, growth, base, or harvesting businesses. Depending on their portfolio role, units have different strategic priorities. Development businesses focus on building a defendable position in their market; growth businesses focus on exploiting growth opportunities and improving their market position; base businesses concentrate on securing a foothold in the market but not necessarily on extending their reach or chasing new growth opportunities; and harvesting businesses explicitly do not search for growth but instead focus on extracting the maximum remaining value.
The role of each business determines the guidelines that apply to capital allocation. For example, coal power generation is classified as a mature harvesting business, so its capital expenses are limited to mandatory investments, effectively shrinking its asset base. This approach frees up money for investments in the renewables segment, which, as a growth business, is allowed to invest up to three times its own cash flow from operations.
Additionally, a corporate center can manage its investment program by regularly analyzing the overall risk-return profile of its portfolio of initiatives. By doing this, the energy company discovered that it had too many low-risk, low-return activities and just a few big, risky ones with high potential returns. As a result, management changed its investment strategy and encouraged units to pursue more small investments with high-risk and high-reward potential to improve the balance across the portfolio. A tech company that undertook a similar analysis realized that it was spending too much on maintaining legacy systems and incremental, low-risk user experience improvements, and was not investing sufficiently in new platforms and customer journey transformations.
Beyond strategic capital budgeting, thriving multi-business companies also excel in the selection of major investments and apply rigorous governance mechanisms to support and track them. Over time, such strategic and financial diligence in capital allocation tends to pay off in terms of superior growth rates and return on capital. Those results come from strong corporate-level judgment skills, learning, and adaptation. While post-completion audits for large initiatives are common in many companies, few companies regularly feed the learnings back into the selection process. To do that effectively, they need to review not only past activities but also past decisions about which ideas to pursue. As the head of corporate strategy at a large, successful industrial conglomerate told us, “We made our biggest losses from moves not made. So, we also explicitly review opportunity cost mistakes.”
Evidence suggests that the corporate diversification discussion should not revolve around whether the conglomerate model is dead or out of fashion, because in many cases it is working quite well. The more useful question to ask is how multi-business companies can manage their portfolios for success. Limiting the number of business models, choosing the right parenting strategy, and allocating capital based on strategic portfolio roles may well make the difference between a diversification premium and a diversification discount.
1. M. Pooler and P. McGee, “U.S. Hedge Funds Join Chorus for Change at Europe’s Conglomerates,” Financial Times, Aug. 20, 2018.
2. M.C. Jensen, “Eclipse of the Public Corporation,” Harvard Business Review, September-October 1989.
3. J.M. Campa and S. Kedia, “Explaining the Diversification Discount,” The Journal of Finance 57, no. 4 (August 2002): 1,731-1,762; and D.J. Miller, “Firms’ Technological Resources and the Performance Effects of Diversification: A Longitudinal Study,” Strategic Management Journal 25, no. 11 (November 2004): 1,097-1,119.
4. J.R. Pierce and H. Aguinis, “The Too-Much-of-a-Good-Thing Effect in Management,” Journal of Management 39, no. 2 (Feb. 1, 2013): 313-338.
5. M.A. Hitt, R.D. Ireland, and R.E. Hoskisson, “Strategic Management: Competitiveness and Globalization” (Boston: Cengage Learning, 2015).
6. K. Lee, M.W. Peng, and K. Lee, “From Diversification Premium to Diversification Discount During Institutional Transitions,” Journal of World Business 43, no. 1 (2008): 47-65.
7. T.B. Mackey, J.B. Barney, and J.P. Dotson, “Corporate Diversification and the Value of Individual Firms: A Bayesian Approach,” Strategic Management Journal 38, no. 2 (February 2017): 322-341.
8. R.A. D’Aveni, “Choosing Scope Over Focus,” MIT Sloan Management Review 58, no. 4 (summer 2017), 22-26.
9. M. Schommer, A. Richter, and A. Karna, “Does the Diversification-Firm Performance Relationship Change Over Time? A Meta-Analytical Review,” Journal of Management Studies, forthcoming.
10. V. Kuppuswamy and B. Villalonga, “Does Diversification Create Value in the Presence of External Financing Constraints? Evidence From the 2007-2009 Financial Crisis,” Management Science 62, no. 4 (April 2016): 905-1,224.
11. D.J. Teece, “Business Models, Business Strategy, and Innovation,” Long Range Planning 43, no. 2-3 (April 2010): 172-194.
12. A. Karna, A. Richter, and E. Riesenkampff, “Revisiting the Role of the Environment in the Capabilities-Financial Performance Relationship: A Meta-Analysis,” Strategic Management Journal 37, no. 6 (June 2016): 1,154-1,173.
13. Danaher analysis draws on several case studies: J.R. Wells and G. Ellsworth, “Danaher Corporation, 2007-2017,” Harvard Business School Case 717-464 (January 2017); B. Anand, D.J. Collis, and S. Hood, “Danaher Corporation,” Harvard Business School Case 708-445 (February 2008); and L.J. Bourgeois III and S. Nadathur, “Danaher — The Making of a Conglomerate,” Case BP-0549 (March 31, 2010), Darden Business Publishing.
14. A. Campbell, M. Goold, and M. Alexander, “Corporate Strategy: The Quest for Parenting Advantage,” Harvard Business Review 73, no. 2 (March-April 1995).
15. M. Krühler, U. Pidun, and H. Rubner, “How to Be a Good Corporate Parent,” Boston Consulting Group, March 22, 2012.
16. U. Pidun and S. Stange, “The Art of Capital Allocation,” Boston Consulting Group, March 27, 2017.